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Big threat to your portfolio is overpaying for active funds, not being misled by index funds

2015-01-03

NEW YORK — If you’re worried that your index fund won’t fare as well as one run by stock pickers in the next bear market, you’re probably fretting about the wrong thing.

Yes, simply tracking the main benchmarks looks especially appealing in a bull market, and less attractive in bad times. And yes, the best-known index funds weight their stock holdings by each company’s stock-market value, so more defensive plays — which often outperform in bad times — can end up a bit ignored.

A popular recent MarketWatch column by Conrad de Aenlle that cites newsletter writer James Stack says all that and then goes further. It suggests investors in index funds will face steeper losses in the next bear market than users of actively managed funds — those conventional, pricier funds run by stock pickers. That, the column says, is where index funds can mislead investors.

History makes a different case. Most active funds underperformed their benchmark indexes in the 2008 bear market, as detailed in the S&P Indices Versus Active Funds Scorecard for that year. “The belief that bear markets favor active management is a myth,” S&P said at the time, adding that results were similar for the 2000-02 bear market.

Yes, some fund managers can beat the market — even indexing pioneer Vanguard likes to talk about that — but the majority don’t, regardless of whether they’re facing a bear or a bull.

Another worry cited in the de Aenlle column is the amount of money flowing into index funds. It contends that so much indexing can raise volatility and reduce diversification. That’s a concern shared by another MarketWatch columnist, Jeff Reeves, who notes the flood into passive funds could overheat certain stocks or even entire asset classes.

Why might such worries be overdone? For one, index funds are still a significant minority of all investable assets, as one Vanguard analyst told MarketWatch in August. (Active funds had 63% of stock-fund assets as of Sept. 30, de Aenlle notes.) Plus, the profit motive ensures there always will be investors making active bets. Even picking your own unique mix of passive funds is an active choice that helps along the market’s price-setting process. Also see: 5 things you don’t know about Vanguard.

Rather than worrying about being misled by index funds and whether too much money is headed their way, you’re probably better off fretting over whether you are invested in active funds that underperform and charge relatively high fees. Author William Bernstein has argued that most mutual-fund providers “spew more toxic waste into the investment environment than a third-world refinery.”

After checking your holdings, read up on a controversial new breed of index funds — smart-beta ETFs — that aim to enhance returns or minimize risk relative to market-cap-weighted indexes. They’re often described as a way to replace pricey active managers.

Critics of smart-beta ETFs say they don’t outperform on a risk-adjusted basis, while costing more than plain-vanilla passive funds. The debate can get fierce. But smart-beta ETFs are drawing in cash; assets under management jumped 28% in the 12 months ended June 30, according to Morningstar, which prefers to describe to them as strategic-beta ETFs.

Focusing on low-cost funds, whether they’re active or passive, is likely more important, according to some experts. Vanguard founder Jack Bogle warned in September that fees paid to active managers could end up equaling a huge amount of lost return, up to 80% of your gains, over a lifetime.